While the market focuses on Alstom's ambitious deleveraging plan and its efforts to navigate the choppy waters of post-Bombardier integration, a quiet revolution is brewing within the company. A shift in strategy, subtly revealed in the latest earnings transcripts, points towards a powerful driver of future cash flow – one that might be flying under the radar of most analysts.

Alstom, for years, has been a titan in the rolling stock industry, building high-speed trains, metros, and trams that crisscross the globe. This capital-intensive business, while impressive, comes with inherent lumpiness in cash flow, a fact readily acknowledged by CFO Bernard Delpit in recent calls. But a closer look reveals a strategic pivot – a deliberate move towards expanding the services segment, a move with far-reaching implications.

Services, encompassing maintenance, modernization, and support for existing rolling stock, provide a more consistent and predictable revenue stream than the one-off nature of new train deliveries. This shift isn't just talk. The numbers tell a compelling story.

In the recent Q3 earnings call, Delpit proudly highlighted double-digit organic growth in the services segment over the past nine months. Furthermore, the company secured two massive service contracts, one in the UK and one in Australia, each valued at nearly €1 billion. These contracts represent more than just one-time windfalls; they signify a growing reliance on Alstom for long-term fleet maintenance, cementing its position as a trusted partner.

Looking ahead, the Q4 2023 earnings transcript reveals that Alstom expects this service-driven momentum to continue, anticipating a book-to-bill ratio “largely above one over the next few years.” This consistent order intake will drive the service backlog to unprecedented levels, potentially reaching parity with the rolling stock backlog in just three years. This represents a seismic shift in the company’s makeup and a sign of things to come.

"The allure of services extends beyond its steady revenue. Services boast a healthy mid-teens profitability, consistently exceeding the margins seen in the more volatile rolling stock business. This profitability, combined with the steady order intake, positions services as a crucial lever in Alstom's ambitious plan to reach an adjusted EBIT margin of 8% to 10% by FY 2026/27."

Delpit, however, acknowledges the inherent trade-off. Building this service behemoth requires upfront investment in CapEx and working capital. He reassures investors, stating, “We expect these efforts to pay off with progressively an improved mix and increased predictability of our numbers.”

Here’s where the hidden cash cow emerges. As Alstom grows its service backlog, its average percentage of completion for these projects will naturally rise. This means the company will shift from the cash-intensive development phase of service contracts to the more rewarding delivery and invoicing phase. This transition, combined with the inherently higher profitability of services, has the potential to unlock significant cash flow in the coming years.

Projected Service Backlog Growth

The chart below depicts the projected growth of Alstom's service backlog, anticipated to reach parity with the rolling stock backlog within three years.

While the exact magnitude of this potential cash flow remains undisclosed, Alstom’s commitment to generating at least €1.5 billion of free cash flow over the next three years provides a tantalizing clue. Consider this: In the past year, despite facing headwinds from the ramp-up in rolling stock production and the drag from loss-making legacy contracts, the company achieved positive free cash flow of €562 million in the second half alone.

"Hypothesis: Assuming a conservative scenario where free cash flow grows linearly over the next three years, and factoring in the €562 million already generated, Alstom could be on track to generate close to €900 million of free cash flow from services alone by FY 2026/27. This figure, combined with the ongoing margin improvements in rolling stock and signaling segments, could propel the company far beyond its €1.5 billion target."

Alstom's strategic focus on services could be the catalyst that propels the company into a new era of profitability and financial strength. While the market obsesses over the immediate challenges, a quiet and potentially explosive growth engine is silently gaining momentum. It’s time to pay attention to Alstom’s secret weapon – the service segment, a cash cow quietly mooing in the corner, ready to unleash its full potential.

"Fun Fact: Alstom built the world's fastest train, the TGV POS, which reached a record speed of 574.8 km/h (357.2 mph) in 2007. This feat cemented Alstom's position as a technological leader in the high-speed rail industry."